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On April 24, the news that Franklin Templeton, a highly-reputed fund house, would close down six debt funds sent shock waves among investors. The fund house attributed the closures to lack of liquidity and the high level of redemption pressure it was facing. Hopefully you are not among those whose money is stuck in those six funds (totaling around Rs 25,000 crore). Those investors face uncertainty not only regarding when their money will be returned but also about how much they will finally see.
Chasing higher risk: Even for those not directly involved, this episode carries several useful lessons. The fund manager invested in lower-grade papers in a bid to generate alpha in debt funds. While such a strategy may be pursued in credit-oriented funds, what was completely wrong was assuming higher credit as well as duration risk in shorter-duration funds, which most investors assume are low-risk in nature.
All this did not happen overnight. This was the denouement to risk that has been building up within the debt market for almost half a decade. Many corporates have defaulted on their debt repayment obligations and many more have been downgraded. IL&FS, DHFL, Essel, Yes Bank, R Com, Amtek, etc. have all contributed to the build-up of pressure within the credit markets in one way or the other.
These defaults and downgrades had an impact on the overall market. Liquidity started to become selective. On the one hand, yields of papers regarded as risky were rising while at the same time banks were depositing upward of Rs 1 lakh crore daily in the Reserve Bank of India’s (RBI) reverse repo window. Even though liquidity was abundant within the banking system, banks preferred to earn low interest by parking their funds with the RBI rather than make risky advances to earn higher interest.
Franklin Templeton has always been known for investing in higher-risk, lower rated papers to earn high returns. The fund manager was well known in the industry for his understanding of credit risk. There is no reason to believe that the fund house or the fund manager deliberately did things that jeopardised investors’ interests. Yet, in hindsight, it appears they overlooked the fact that a higher-risk strategy that works in a benign environment can spell trouble in a market where liquidity has dried up and a high level of risk aversion has crept in. As the more knowledgeable investors withdrew their money from Franklin’s funds, the fund house found it impossible to cope with the high level of redemption and was forced to throw in the towel.
Chasing higher risk: Even for those not directly involved, this episode carries several useful lessons. The fund manager invested in lower-grade papers in a bid to generate alpha in debt funds. While such a strategy may be pursued in credit-oriented funds, what was completely wrong was assuming higher credit as well as duration risk in shorter-duration funds, which most investors assume are low-risk in nature.
All this did not happen overnight. This was the denouement to risk that has been building up within the debt market for almost half a decade. Many corporates have defaulted on their debt repayment obligations and many more have been downgraded. IL&FS, DHFL, Essel, Yes Bank, R Com, Amtek, etc. have all contributed to the build-up of pressure within the credit markets in one way or the other.
These defaults and downgrades had an impact on the overall market. Liquidity started to become selective. On the one hand, yields of papers regarded as risky were rising while at the same time banks were depositing upward of Rs 1 lakh crore daily in the Reserve Bank of India’s (RBI) reverse repo window. Even though liquidity was abundant within the banking system, banks preferred to earn low interest by parking their funds with the RBI rather than make risky advances to earn higher interest.
Franklin Templeton has always been known for investing in higher-risk, lower rated papers to earn high returns. The fund manager was well known in the industry for his understanding of credit risk. There is no reason to believe that the fund house or the fund manager deliberately did things that jeopardised investors’ interests. Yet, in hindsight, it appears they overlooked the fact that a higher-risk strategy that works in a benign environment can spell trouble in a market where liquidity has dried up and a high level of risk aversion has crept in. As the more knowledgeable investors withdrew their money from Franklin’s funds, the fund house found it impossible to cope with the high level of redemption and was forced to throw in the towel.
